January 17, 2012

The MF Global debacle has shown that the way Futures Commission Merchants (FCMs) manage client assets can be -- how should I say this -- somewhat lacking. Given the unsound practices, lack of internal controls and poor oversight displayed throughout the MF Global mess, I'm not sure if we need to rethink regulatory practices governing how FCMs manage client money or scratch the system altogether and start anew.

Until the CFTC updated the rules that govern the investing of customer cash, Regulation 1.25, FCMs had fairly flexible reign in how they "invested" client assets (the new rules go into effect Feb. 17). As long as relatively safe assets were pledged as collateral, FCMs lent client funds to internally owned broker-dealers, which used it as inexpensive funding. Practically, MF Global clients were engaged in "hold in custody" repurchase agreements, or repo, theoretically collateralized against some "relatively safe" dealer inventory. While collateral was supposed to be segregated, however, dealers were never required to inform the client of what collateral was pledged against their cash,

Years ago securities dealers also could collateralize internal institutional repo without letting the client know what was being used as the collateral. It was done on the dealer's word and no third parties were involved. No one even checked to confirm that the same collateral wasn't allocated multiple times. Internally, we called these "Trust Me" repos. Thankfully, "Trust Me" repos stopped in the late '80s for institutional clients with the advent of tri-party repo, in which the collateral was physically segregated to a third-party custodian that also valued and verified these transactions.

Under the new Regulation 1.25 rules, internal repo transactions also will be a thing of the past. FCMs will need to physically move clients' excess cash to a third party for overnight investment. To avoid excess concentration of risk, this cash must be placed with at least four unaffiliated dealers, with no single dealer getting more than 25 percent. The cash only will be allowed to be invested in very safe investments that can lose no more than 1 percent of their value overnight. The approved list of investments is very short; it includes U.S. government-guaranteed debt and debt issued by organizations that the U.S. government has backed through secured lending programs, as well as short-term commercial paper, certificates of deposit and high-quality municipal bonds, or munis. Foreign sovereign debt is, as its name suggests, excluded from the list of acceptable investment opportunities.

While this is a step in the right direction, it is not without its challenges. Perhaps the biggest questions are: Where will we get access to so much U.S. guaranteed debt? And which banks will take the money? Obtaining access to vast amounts of U.S. Treasuries will be difficult, as most Treasuries are pledged against institutional financings. Even if all guaranteed U.S. debt is allowable, there may not be that much excess collateral available -- especially given the collateral demands required to back the central clearing of OTC derivatives as mandated by Dodd-Frank.

Unless the new Regulation 1.25 rules are repealed, which is unlikely, we can expect a very significant squeeze on U.S. government-guaranteed debt, pushing yields lower and prices higher, initiating the repatriation of U.S. debt from around the globe. It also is likely to push short-term yields into the negative territory, especially for futures clients.

Another problem with investing so much overnight cash is the possibility that banks may not want it. Under new Basel III liquidity requirements, banks accepting short-term money will need a greater supply of longer-term, less-flight-prone deposits. This will increase banks' funding costs, which most likely will be pushed back on clients that hold cash balances in futures margin accounts. As a result, banks may shy away from taking this cash, or they may be forced to charge a fee for holding it instead of paying the FCM client interest.

In addition to overcoming these funding abnormalities, other steps also must be taken to prevent another FCM failure (see sidebar). Getting this process correct not only is critical for moving past the MF Global disaster, it is critical to bring back faith in our financial systems, which unfortunately were found to be lacking.

Larry Tabb is founder and CEO of Tabb Group.

SIDEBAR: Restoring Faith in the Futures Market


While the CFTC's proposed changes to Regulation 1.25 will go a long way toward protecting investors' funds, more can be done to restore faith in the futures market, according to Larry Tabb, who suggests the following requirements:

  • Implement an insurance program for investor funds held by FCMs similar to the FDIC or SIPC.
  • Mandate that cash and segregated collateral be externally controlled.
  • Require confirms detailing the collateral assigned against repurchase agreements.
  • Force operational processes and investment programs to be audited externally and independently.
  • Ensure greater senior management accountability.
  • Develop greater regulatory oversight.